There are many advantages to incorporation. One of the biggest of these is the very low corporate tax rate on what is called small business income, which also applies to professional income. Self-employed professionals who earn high incomes can significantly leverage the power of compounded investment returns and end up with a much higher net worth.
Who Is Allowed to Incorporate?
According to federal income tax law, anybody who is genuinely self-employed in a profession or business is legally entitled to be taxed as a corporation. Historically, there were a few regulated professions where the provincial legislation prohibited incorporation. These have gradually been eliminated in most provinces.
In Ontario, most regulated professionals are now allowed to incorporate, including accountants, lawyers, engineers, social workers, psychologists, dentists, physicians, and a long list of other health professionals governed by the Regulated Health Professions Act. After many years of lobbying, real estate agents have been added to the list of those who are permitted to incorporate, with the enactment of the Trust in Real Estate Services Act in 2020.
An important point to keep in mind is that you must be genuinely self-employed rather than an employee in order to qualify for the tax advantages of incorporation. Occasionally, people who get all or most of their income from one “client” will incorporate in the hope of tax savings and declare themselves self-employed. Canada Revenue is on the alert for that, and it conducts audits to verify that a person really is self-employed. The distinction between an employee versus a self-employed person is not always clear-cut. It depends on factors such as the degree of control and the existence of business risks. For more on that topic, please see this companion article.
Tax Deferral and Savings from Investing within your Corporation
There can be significant tax benefits from incorporation, but they are only available if your business or professional income is large enough to put aside money for investment. You need to have money left over to invest inside the corporation after you have paid yourself enough income to live on.
Governments in Canada love small business and they want to encourage more of it. Professional income from self-employment is considered small business income. Through the generosity of the Small Business Deduction, the combined federal and provincial corporate tax rate on small business income in Ontario is only 12.2% for annual income up to $500,000 as of 2020. That is certainly very much preferable to paying income tax at a rate of 43.5% rate charged on any personal income above $100,000, rising to 53.5% on personal income above $220,000.
The catch is that you only get the low 12.2% tax rates on money that stays within the corporation. If you pay yourself a salary deriving from the profits of your corporation, you will have to pay the regular personal income tax rate on this. The effective tax rate on dividends has also been set so that the combined tax you pay on corporate income and personal tax will be about the same as if you were not incorporated.
It is only when your income is high enough to keep money in the corporation that you get an effective benefit from this low corporate tax rate.
There are two things that you can do with this money. First, if you have a growing business or professional practice, you can invest your money to buy assets that you need for the operation of your business, such as inventory, equipment or office facilities. The additional profits you earn from the resulting growth of your business will compound more rapidly, as you are only losing 12.2% of it to tax each year (until you reach the $500,000 limit).
Alternatively, you may be planning towards retirement and not aiming to grow the business further. You can set up an investment account in the name of your corporation with a brokerage firm. You can buy shares of publicly traded companies in the stock market, and earn dividends or capital gains within the corporation. This kind of investment income is “passive income” that is not counted as business income for the purpose of the Small Business Deduction. Therefore, your corporation will pay a higher corporate tax rate on it, which is about the same rate you would pay outside a corporation. However, it still gives you a significant benefit through tax deferral.
Suppose your personal income tax rate would be 53.5% if you were unincorporated. Then, for each dollar of income you earned from your profession, you will only have 46.5 cents left to invest after paying tax. However, if you had earned your professional income in a corporation, you would have started with 87.8 cents on the dollar to invest (after paying your 12.2% corporate tax). You will be earning your investment income on a much larger amount of capital.
Compounded over many years, you will end up with considerably more when you retire and eventually withdraw the money from your corporation. For example, suppose that Taxpayer A with a corporation makes $100,000 and keeps it invested in passive investments in the hands of the corporation, earning a dividend yield of 5% there for 30 years. Taxpayer B is in the same situation, but is unincorporated and so pays full personal tax on his income before he gets to invest it.
Taxpayer A, after paying corporate tax, has $87,800 left to invest out of the $100,000. She would end up with about $180,000 after tax when she pays herself a dividend from the corporation 30 years later.
Taxpayer B only has $46,500 left to put into investments because he paid 53.5% personal tax on his high personal income from his unincorporated professional practice. He would end with as little as $110,000 after 30 years. (The amount could vary, depending on the amount of unused RRSP or TFSA contribution room.)
If you earn more than $50,000 of passive investment income per year within the corporation, it will reduce your maximum Small Business Deduction. However, capital gains are only counted when the property is sold, meaning that you can accumulate more than $1 million of passive investments if you put more of it into growth stocks rather than high dividend yield stocks. That of course assumes you are successful in picking stocks that do actually grow
Income-Splitting through Dividends to Family Members
Depending on your age and family situation, there could also be tax savings through designating some of the shares for other members of your family who are in lower tax brackets, known as income-splitting. This option has been somewhat curtailed by tax law changes made in 2018, but it is far from having been eliminated.
If a corporation has an excluded business, dividends can still be paid to shareholders above the age of 25 much as before. This creates an opportunity for significant reductions in the overall tax burden for the family if there are other family members who are in lower tax brackets. However, most professional corporations do not qualify for this. As well, even younger family members may receive dividends without paying TOSI if they are actively engaged in the business (working more than 20 hours per week).
One opportunity for income-splitting that is available with a professional corporation is for older owners that have accumulated assets that earn passive income (e.g., from stocks and bonds). Once the primary owner reaches the age of 65, dividends can be paid out to his or her spouse and taxed at the latter’s tax rate. That is something to consider for the future even if you are currently much younger than 65.
Still another potential benefit is the Lifetime Capital Gains Exemption (LCGE) on the sale of small business shares, which is currently almost $900,000. If you sell shares representing the value of assets actively used in business accumulated within your corporation, this will be completely tax free up to the LCGE limit. Therefore, if you had the opportunity to invest and buy assets used within a growing active business, you may qualify to take out your savings entirely tax free. That can create a very nice retirement nest egg when you exit your business. Income splitting remains available for the LCGE. The LCGE limit is a limit per person, not per corporation. Therefore, if more than one family member owns shares, the total LCGE for a corporation can be multiplied.
Smoothing out Volatile Income
This can be a big benefit for people who are in the kind of business that alternates between boom and bust. In bad years, such a person may earn little or no income, while in good years the income can be quite high. Averaged out over good and bad years, this person’s income might be at a level where the tax rate is only 40%. In the good years, it might be taxed at the top marginal tax rate of 53.5%.
If you are in this kind of situation, you can save on income tax by keeping money in the corporation in the good years, to avoid very high personal tax rates. It can be paid out to you as salary or dividends in the weak years when your top income is in a lower tax bracket. This can be particularly important for professionals such as real estate agents, due to the historic cyclicality of the real estate market.
What Are the Costs of Incorporation?
The cost of incorporating can vary considerably, and you will find cheap options advertised on-line. If you want to ensure that it is done right, and you want documents in place that allow you to have multiple classes of shares for business or tax planning purposes, then you may want to hire a lawyer to advise you about it. The cost (including government filing fees) of getting it done professionally can vary from about $2,500 upwards, depending on the complexity.
This cost of incorporation is a one-time cost. However, unless you have the capacity to do it yourself, you will also need to retain a professional to prepare annual minute books and tax returns for the corporation, which is an ongoing expense.
Does Incorporation Limit Your Liability?
The corporate form emerged in the distant past before income taxes were invented. The classic reason for incorporation was to limit liability. If you run a business that is not incorporated, creditors of that business can come after your personal assets such as your house until all the debts of the business are paid off. Limited liability means that the shareholder is not personally responsible for debts of the corporation. He can only lose as much as he has invested in it.
The limitation of liability may be unreliable for the owner of a small business corporation. It is only fully reliable for shareholders who are passive investors. An owner-operator who is taken to court will sometimes still be held to be personally liable, in what is known as “piercing the corporate veil.” It can be hard to predict when this will happen, as it depends on the facts of each case. In addition, landlords and major lenders almost always require leases and loans entered into by a small corporation to be personally guaranteed by the owner.
In the case of people in a regulated profession, the shield of incorporation is even weaker. The statutes allowing incorporation typically state that the individual will be personally liable for any claims related to damages from professional negligence. Nevertheless, there still could be limited liability for general business debts of the corporation, with the usual caveat about piercing the corporate veil.
Peter Spiro is counsel to Rogerson Law Group for tax and estate litigation and planning. This article is for general information purposes and you should seek specific advice for your particular case. This article was originally published by The Lawyer’s Daily, (www.thelawyersdaily.ca) a division of LexisNexis Canada.